FINANCIAL MANAGEMENT – P10

Solution 1

(a)
Ratio Calculations
(i) Inventory turnover 2018 2017
Cost of sales 45,000 39,700
  
Average Inventory (31,000  26,000) (22,000  31,000)
2 2
= 1.6 times = 1.5 times
Comment:

During 2016 inventory turned 1.5 times into sales and increased by 0.1 times in
2017.This implies that the rate at which KIKA Ltd’s inventory is converted into
sales has improved though at a low rate.

Ratio Calculations
(ii) Return on Assets 2018 2017

Earnings after tax 11,200 10,570

  100  x 100
Total assets 171,000 161,900
= 6.55% = 6.52%

Comment:

In 2018, ROA was slightly better than 2017 by 0.03%. This signifies an
improvement in management efficiency in using its assets to generate profits.
The company is in a slightly better profitability position.

Long term debt

Debt : equity ratio =
Equity

(iii)Debt equity ratio 2018 2017

50,000 46,000
 100   100
(40,000  10,000  20,000) (40,000  10,000  19,000)
= 71% = 67%

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Comment:

This shows that in 2018, 71% of the capital was borrowed than in 2017 which
was 67%. It shows that the company may fail to meet its obligations in future.

PBIT
(iv) Return on Capital Employed (ROCE) =
Capital Employed

ROCE 2018 2017

26,000 24,300
  100   100
125,500 115,000
= 20.72% = 21.13%

Comment:
The return on total fixed assets has increased which shows that the business is
profitable.

(b) Financial statement analysis through ratios is useful because they highlight
relationship between items in the financial statements. However, they
have a number of limitations which should be kept in mind while preparing
or using them.

- Ratios are based on accounting figures given in the financial statements.

However, accounting figures are subject to deficiencies, approximations,
and diversity in practice or even manipulation. This makes them not
helpful in drawing reliable conclusions.
- Inflation may limit the utility of accounting ratios. Due to inflation,
historical cost based financial statements and accounting figures do not
reflect current values especially in the case of assets purchased at different
dates by different enterprises.
- The different methods of computing also influence the utility of ratios. The
different concepts used for determining numerator and denominator in a
particular accounting ratio will not help in drawing reliable conclusion.
- Ratios have inherent problem of comparability. Companies though similar,
may employ different accounting methods which makes it difficult to
compare certain key relationships for example some companies use LIFO
while others use FIFO methods of inventory valuation.

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 - Ratio analysis is largely quantitative and yet there are qualitative factors
like quality of labour and loyalty of the employees which might be
significant in comparing different companies.

(c) WACC
Sources of capital Shs
20% long term loan 50,000
Ordinary share capital 40,000
10% preference shares 10,000
Retained profits 25,500
125,500
Calculations for individual costs of capital

- Cost of debt Kd = 20%

- Cost of preference share = 10%
- Cost of equity (Ke)

Kℯ = D0 (1+g) + g
PO
D1 = 2,000
P1 = 20,000
g = 0.07

2,000
Ke= 1.07  0.07
20,000
=0.177
=17.7%

Weights of each source of capital;

Weight
20% long term debt 0.40

Common stock 0.32

10% preference share 0.08

Retained profits 0.20

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 Multiply specific costs and their weights.
Source Amount Proportion Specific Weighted
‘000 Weight Cost cost
20% long term debt 50,000 0.4 0.20 0.08
Ordinary share capital 40,000 0.32 0.177 0.0566
10% preference share 10,000 0.08 0.10 0.0080
Retained profits 25,500 0.2 0.177 0.0354
TOTAL 125,500 0.1804
WACC = 18%
Weighted Marginal Average Cost of Capital
Weights of individual sources of additional capital

Source Amount Shs ‘000’ Proportion

10% bonds 40,000 0.40

Common stock 20,000 0.20

12% preference shares 10,000 0.10

Retained earnings 30,000 0.30

100,000
Specific cost of additional capital
Cost of bond = 10%
Cost of preference share = 12%
Cost of new equity (Kℯ)
Kℯ = D1 + = .

Multiply specific costs and their weights

Source Amount Proportion Specific Weighted

‘000’ Weight Costs Costs
10% bond 40,000 0.40 0.10 0.040
Common stock 20,000 0.20 0.21 0.042
12% preference shares 10,000 0.10 0.12 0.012
Retained earnings 30,000 0.30 0.21 0.063
TOTAL 100,000 0.157

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Marginal weighted average cost of capital = 0.157 = 16%

(d) NPV Calculations

Year Cash flow inflow DCF 16% PV
‘000’
0 (100,000) 1.000 (100,000)
1–5 35,000 3.274 114,590
NPV 14,590

Since the project gives a positive Net present value of Shs 14,590 it’s viable and
therefore may be undertaken.

Solution 2

a)
 The methods PMFL could use to assess the creditworthiness of a customer
or a potential customer include:
 A bank reference – while a bank reference can be fairly and easily
obtained, it must be remembered that the other company is the bank’s
customer and so a bank reference will stick to the facts.
 A trade reference – this is obtained from another company who has
dealings with your potential customer. Due to the litigious nature of
society these days, it may not be so easy to obtain a written reference.
However, you may be able to call contacts you have in the trade and
obtain an informal oral reference.
 Credit rating/reference agency – these agencies’ professional business is to
sell information about companies and individuals. Hence, they will be keen
to give you the best possible information, so you are more likely to return
and use their services again.
 Financial statements – financial statements of a company are publicly
available information and can be quickly and easily obtained. While an
analysis of the financial statements may indicate whether or not a
company should be granted credit, it must be remembered that the
financial statements available could be out of date and may have been
manipulated. For larger companies, an analysis of their accounting
information can generally be found through various sources on the internet
 Information from the financial media – information in the national and
local press, and in suitable trade journals and on the internet, may give an
indication of the current situation of a company. For example, if it has
been reported that a large contract has been lost or that one or more

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 directors has left recently, then this may indicate that the company has
problems
 Visit – visiting a potential new customer to discuss their exact needs is
likely to impress the customer with regard to your desire to provide a good
service. At the same time, it gives you the opportunity to get a feel for
whether or not the business is one which you are happy to give credit to.
While it is not a very scientific approach, it can often work quite well, as
anyone who runs their own successful business is likely to know what a
good business looks, feels and smells like!

b) The Capital Markets Authority (CMA)

The Capital Markets Authority (CMA) is an autonomous body, established in 1996
under the Capital Markets Authority Act (Cap 84) 1996, to promote, develop and
regulate the capital markets industry. CMA is governed by a Board of Directors
appointed by the Minister of Finance, Planning and Economic Development.

The CMA is mandated by law to carry out the following regulatory functions:
a) Approval and supervision of Stock Exchanges and securities central
depositories.
b) Approval of all public offers of securities.
c) Regulation of collective investment schemes.
d) Licensing of market intermediaries.
e) Ensuring proper conduct of all market intermediaries.
The other functions of the Capital Markets Authority are;

(a) The development of all aspects of the capital markets with particular
emphasis on the removal of impediments to, and the creation of incentives for,
longer term investments in productive enterprise;

(b) the creation, maintenance and regulation, through implementation of a

system in which the market participants are self-regulatory to the maximum
practicable extent, of a market in which securities can be issued and traded in an
orderly, fair and efficient manner; in other words to create, maintain and
regulate a market in which securities can be issued and traded in an orderly, fair
and efficient manner.

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 (c) The protection of investor interests; and

(d) The operation of a compensation fund as provided for in section 81.

(2) For the purpose of carrying out its objectives, the authority may
exercise, perform and discharge all and any of the following powers,
duties and functions.

(a) Advise the Minister on all matters relating to the development and operation
of Capital Markets;

(b) Maintain surveillance over securities to ensure orderly, fair and equitable
dealings in securities;

(c) register, license, authorize or regulate, in accordance with this Act or any
regulations made under it, stock exchanges, investment advisers, registrars,
securities broker or dealers, and their agents and control and supervise their
activities with a view to maintaining proper standards of conduct and
professionalism in the securities business;

(d) Formulate principles for the guidance of the securities industry;

(e) Monitor the solvency of licence holders and take measures to protect the
interest of customers where the solvency of any licence holder is in doubt;

(f) Protect the integrity of the securities market against any abuses arising from
the practice of insider trading;

(g) Adopt measures to minimize and supervise any conflict of interest that may
arise for brokers or dealers;

(h) Create the necessary environment for the orderly growth and development of
the capital market;

(i) perform the functions conferred on it by section 42 of the Companies Act;

(j) Undertake such other activities as are necessary or expedient for giving full
effect to the provisions of this Act; and

(k) Do anything which is likely to facilitate the discharge of its functions, or is

incidental or conducive to their discharge, under this Act.

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 c) The role of management in meeting stakeholder objectives.

The role of management in meeting stakeholders is to ensure that a balance is

struck between the conflicting objectives and, hence, strive to satisfy the
objectives of all stakeholders.

This can be done by;

 Understanding the objectives of different stake holders;

 Providing information about the need to balance the conflicting objectives
in order to ensure the long-term survival of the business.
 Complying with the regulation and laws i.e. paying taxes on time
 Protecting the environment; avoiding polluting the environment
 Carrying out corporate social responsibility; i.e. paying school fees for
locals, engaging in community programs etc
 Provision of jobs and job security to qualified people from the community
where the business is located.
 Producing high quality goods and services
 Paying service providers and suppliers on time

Solution 3
(a) (i) Convertible debt stocks are the financial instruments which may be
converted into equity of the company at the option of the holder at the
predetermined price and number of shares. When the holder doesn’t convert
because debt is more worth being held as debt instead of equity, the debt will
be redeemed. This could be because the predetermined price is greater than
the market price ruling.
The cost of convertible debt is the internal rate of return.
On assumption that the holder will convert, the conversion value will be;

10 shares x 120 = Shs 1200

The ex- int price of the debt is cum int price minus the interest
The interest is the coupon rate x nominal value
Interest= 10%x 100 =10
Therefore the ex-int price will equal 850-10 = 840

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Therefore, the cost of the convertible debenture will be;
Year Cash flows 8%
DCF PV
0 (840) 1 (840)
1 -5 10 3.9927 39.927
5 1200 0.6805 816.6
NPV 16.527

Year Cash flows 10%

DCF PV
0 (840) 1 (840)
1 -5 10 3.791 37.91
5 1200 0.621 745.2
NPV (56.9)

 P 
IRR = a   b  a 
PN 
a = lower rate
b = higher rate
P = positive NPV
N = negative NPV

 16.927 
IRR = 8 +  2
 16.927  56.91 

= 8.5%
Cost of the irredeemable debt stock
Cost of irredeemable debt stock
i
Kd=
Pd
Kd = cost of debt
i = interest
pd = price of debt
i = coupon rate x nominal value
15 x 100 = 15
Pd = 100 x 1.12 = 112
Therefore, Kd =

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ii) Advantages of convertible debt stock.
- They offer a company immediate finance at lower cost since the
conversion option normally means that borrowing can be raised at below
normal rate.
- They act as alternative to share issue when share prices are depressed.
- They are self-liquidating when they are converted into shares, the problem
of payment disappears.
- The option involves repayment of extra cash to the company which can be
an extra source of funds.

(b) Why diligence should be exercised when making capital budgeting

decisions?
- Large size of funds is required
Capital expenditure decisions require large amounts for acquisition of fixed
assets or for implementing big projects. It is essential that large funds
should be invested in most profitable alternatives after thorough appraisal.
- Irreversible decisions
Capital budgeting decisions are irreversible and amounts invested may not
be realized back. The reason is that they may not be market for second
hand fixed assets nor there is a possibility of conversion of such assets into
other profitable alternative use.
- Associated risks
Long term investments are exposed to different types of risks. The longer
the period of the project, the greater, may be the risk and uncertainty.
- Long term effect
The capital budgeting decisions have long term effects on the future
profitability and cost structure of the firm.

- Impact on firm’s competitive strengths

The capital budgeting decisions affect the capacity and strength of the firm
to face competition. Capital investment decisions determine the future
profits and costs for the firm which ultimately affects competitive position
of the firm.
- Most difficult decision
Capital decisions are very difficult to make as their assessment depends on
uncertainty of future events and activities of the firm.

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(c) Factors to consider when assessing the powers of different stakeholders

 The status in society e.g. a bishop, a president

 The budget. A customer who has a big budget and purchases in bulk and
to whom the company is benefiting from can influence the decisions of the
company.
 The legal framework. For example Government will use the existing laws
to achieve their interest in business.
 Skills. Highly skilled employees can influence the decisions of the company
 Competition. If there are competitors in the industry, the customers will
be powerful and vice versa

Solution 4

(a) (i) Future value of annuity (FVFA)

FV = 20m (FVFA for 10years) at 10%

= 20m x 15.937 = 318,740,000

ii) Present value of perpetuity

PV =
i = expected cash flow = 10m
r = interest rate = 10%
PV =

(b)
(i) Distinction between non- discounting techniques and discounting
techniques
Non- discounting techniques are evaluation methods that don’t take
into consideration time value of money while discounting techniques
take into consideration time value of money. The non discounting
techniques assume that passage of time doesn’t affect the value of
money. The discounting techniques consider timing of cash flows as
one of the most important factors to consider while appraising projects.
The discounting techniques stipulate that cash flows accruing in

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 different time periods are having different values and are comparable
only when their present values are found.

(ii) Why payback is most popular despite its shortcomings

 Payback serves as a proxy for certain types of information
which are useful in investment decision- making
 Pay back may be regarded as reciprocal for internal rate of
return when the annual cash flows are constant and the life the
project fairly long.
 The payback period is akin to breakeven point. It serves as
useful short cut in the process of information generation and
evaluation.
 Payback period conveys information about the rate at which
the uncertainty associated with projects is resolved. The longer
the payback period the slower the uncertainty associated with
the project is resolved. Decision makers prefer early resolution
of issues. An early resolution of uncertainty enables decision
maker to make prompt corrective actions, adjust his
consumption patterns and change the investment decisions
(c) Financial analysis is a repetitive exercise which the financial manager has
to carry out in order to assess the strength and weakness in the financial
position and operating results of the firm.

It has the following importance

- Tracking inventory:
Financial analysis helps in proper inventory management. It assists the
financial manager determine whether the organization has enough
inventory to meet the projected sales.
- Determination of profit margin.
By analyzing gross profit margin the company is able to ascertain how
much it costs to produce the company’s products.
- Assess improvement
Financial analysis in form of trend analysis helps to identify periods and
changes that affect your business and take corrective measures after
comparing trends in various years.
- Updates on debts status
Financial analysis helps in determining whether there is enough liquidity to
meet upcoming debt i.e. by current ratio analysis.
- Determine debt to equity mix

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 Financial analysis helps to analyze the percentage of debt compared to
equity. It’s up on this ratio that the company stops borrowing more funds
as it may put the company into liquidation.
- As an investor, by financial analysis you can assess the liquidity,
profitability, financial strength and efficiency of an organization.
This also helps greatly in making good investment decisions.

Solution 5

(a) ( i)Principles of cash management

- To accelerate the cash collection
This could be through giving out incentives to customers to pay earlier.
- Delay cash payment to suppliers
This has to be done with care, without jeopardizing the credit worthiness
of the company.
- Investment of available excess cash
A company should strive to optimize the cash they hold. Any excess cash
should be invested both in long and short term securities.
- Maintenance of minimum cash balance
Cash is a liquid asset an organization has at its disposal. Excessive cash at
hand can be subjected to misuse, loss on the interest that would have
been earned if this money was invested.

ii) With illustrations explain to CEO the cash optimum models.

So many models have been developed to determine the optimum cash
balances of cash to be maintained in the organization. The most popular
ones are two that is Baumol or inventory approach to cash management
and the Miller- orr model.

(i) The inventory approach.

This model is similar to the economic order quantity in inventory
management. Baumol suggests that two types of costs are associated
with cash balance. The first type is transaction costs, which is incurred
when marketable securities are inverted into cash. The second one is
holding cost, this is the benefit foregone due to holding cash balances.
Both costs are variable in nature, when one reduces the other type
increases and vice versa. The minimum cash balance will be reached
when the total cost is minimized.

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 This can be done using a formula or tables.

2 AT
C=
i

C = optimum cash balance

A = requirement of cash
T = transaction costs
i = interest rate

(ii) Miller – orr Model

The Miller-Orr model is used when the demand of cash to stochastic
and not known in advance. When changes in cash occur randomly,
the application of control theory is applied. The model establishes
upper and lower control limits to which cash balances are allowed to
fluctuate.
When the cash balances reach the upper control limit, securities are
purchased in order to reduce cash holding to a desired level. When
cash balances fluctuate to lower control limit, securities are sold to
top up cash back to the desired control level. The desired average
control level is known as the return point where cash is always
pushed either by purchase or sale of securities.

Illustration

The graph describing the three control levels

upper limit

purchase of securities
Return point

Sale of securities
Lower limit
Time

(b) Features of sole proprietorship

 One person owned business
 The owner and business are legally fused
 Has life as longer as the owner lives

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 Characterised by assets and liabilities and equity which belong to
single owner
 Preferred to other forms of business because it is easy to form and
run
 The owner takes all the profits and losses
 It success or failure are determined by the single owner

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